Turning accumulated assets into a reliable income stream is THE critical issue facing retirees. A growing body of research, and memorable terminology, has provided financial planners with the ability to help our clients create a dynamic income plan that best suits their needs.
While each client has a unique set of circumstances, having adequate income to maintain a given lifestyle in retirement is a near universally shared goal. Likewise, many clients will face similar obstacles and challenges throughout retirement. Our job as advisors is to assist clients in identifying their retirement goals, risks, income sources and expenses, and to combine these to help create an income plan that can be revised and adapted over time. In this blog, we will outline three distinct approaches to retirement income planning.
I. The Systematic Withdrawal Approach
This technique involves managing a portfolio of investments and withdrawing a predetermined amount of the portfolio each year to fund living expenses. Income may come from a combination of interest, dividends and capital appreciation. The portfolio is generally diversified across many different types of assets and managed for “total return”, or the maximum return for each incremental unit of risk. Clients familiar with this approach may identify it as “The Four Percent Rule”.
While easy to remember, the actual percentage can vary based on a multitude of factors. Having a well-managed portfolio, good investment results, or a shorter period of distributions, may support a somewhat higher level of withdrawals. The converse, of course, is also true. Using this approach, an advisor may help a client to establish a portfolio withdrawal rate (“safe withdrawal rate”) based on one of several approaches:
- Inflation Adjusted Distribution: the annual distribution amount is established at the time of retirement, based on a safe withdrawal rate. The distribution is increased each year for a pre-determined level of inflation regardless of the portfolio’s value.
- Non Inflation Adjusted Distribution: same as above, but the annual distribution is not increased and remains fixed throughout retirement.
- Adjusted Distribution: in this approach, a safe withdrawal rate is applied against the current value of the portfolio, not the original value. Thus, income will fluctuate each year. During periods of poor market performance a client’s income would be reduced while their income could increase when market returns are better than expected.
- Hybrid Approach: similar to the “Inflation Adjusted Distribution” method. A safe withdrawal rate is established and increased each year for a pre-determined level of inflation. In addition, a performance target is established so that withdrawals are increased or decreased based on material deviations in the performance of the portfolio.
Some positive attributes of a systematic approach include retaining control of the assets, having the possibility of increasing income, and the ability to transfer assets to heirs or a charity. Having guaranteed income sources, such as Social Security or pension income, and reducing withdrawals during periods of poor market performance can enhance the viability of this strategy.
II. The Time Based Segmentation Approach
Also known as “The Bucket Approach”, retirement is segmented into distinct time periods, and distinct pools of assets are managed to fund retirement goals over each period. For example, retirement may be divided into a period from age sixty five to seventy five; another for age seventy five to eighty five; and a final period beyond eighty five. Investments are segmented and invested to provide adequate income over each stage of retirement. Investments for stage one would be quite conservative and designed to provide immediate income, while the investment mix for stages two and three would be incrementally more aggressive. Over time, the assets in the first bucket are replenished by those in the second and the second from the third. The asset allocation, in aggregate, could be very similar to that of the systematic approach, and products such as deferred income annuities could be used to provide protection from outliving assets in the later stages of retirement.
One big advantage to this approach is rooted in behavioral finance- investments are clearly identified and matched against a specific time period. Spending too much money, or concerns about the performance of assets earmarked for long term spending needs may be mitigated by this approach.
III. Essential Versus Discretionary Approach
The term “flooring” is a memorable and commonly used reciprocal to describe this approach, and involves establishing a base level of guaranteed income to support essential spending. Nonessential spending needs are then addressed using withdrawals from investments.
Social Security and guaranteed income annuities are generally used to create the floor, and may offer some level of inflation protection. As with the systematic approach, portfolio withdrawals may be reduced or eliminated during challenging economic periods, and the surplus during especially good years could be used to help increase the amount of guaranteed income.
This approach is also easy to understand and provides the highest level of protection from running out of money entirely. Additionally, there is a behavioral benefit in that a clear distinction is made between essential and non-essential expenses.
IV. Common Risks & Attributes
Retirees face a series of common risks and each of the above approaches has positive and negative attributes. Rising prices, the need for liquidity, living to an advanced age, poor investment performance and overspending are just a few of the risks faced by most.
The Systematic Withdrawal Approach typically maintains the largest and most sustained exposure to equities (stocks) and, thus, may offer the most protection against the ravages of inflation. In contrast, the Essential Versus Discretionary approach generally offers the least protection from inflation due to its reliance on guaranteed income annuities. This, however, may be mitigated by the use of inflation adjusted or variable annuities, when appropriate. For the same reason, these approaches are also at opposite ends of the spectrum as it relates to liquidity provisions.
The Essential Versus Discretionary approach does, however, provide the highest level of protection from outliving one’s income entirely, or overspending in retirement. The Time Based Segmentation approach may also be very effective in this regard, if managed properly.
Poor investment performance is a risk faced by most retirement plans, but may be mitigated by making smart decisions during difficult times. The Systematic Withdrawal approach, not adjusted for market performance, would have proven very risky during the sharp market declines of 2008 and early 2009. In contrast, the Time Segmentation Approach, rooted in behavioral finance, may have helped investors to avoid selling stocks at the worst possible time.
No one approach is right for all clients and hybrids of the outlined approaches may be created. It is important to clearly identify retirement goals, risks and objectives and create a retirement income plan that can be monitored and adjusted over time.
John Male, CFP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
The Retirement Maven ™
9 East 40th Street, Suite 1500
New York, NY 10016